Monday, December 21, 2009

What Went Wrong

Great little wrap up on the crisis from Econbrowser. He highlights the US Treasury's recent proposal for reform of the financial system:
  • Introduce a legal mechanism whereby large financial institutions that are not commercial banks (such as AIG or Bear Stearns) can be liquidated in an orderly manner without bankruptcy or bailouts, analogous to the authority that the FDIC currently has to take over failing banks.
  • Subject the banklike functions of investment banks and structured investment vehicles (that is, the activity of borrowing short and lending long) to the same capital requirements as standard banking.
  • Require either mortgage originators or the mortgage securitizers to retain 5 percent of the product they create. I would take that idea a step farther, endorsing Princeton Professor Alan Blinder's proposal that originators and securitizers should each hold 5 percent.
  • Move the trading of financial derivatives like credit default swaps to centralized exchanges where they would be subject to a robust regime of regulation including conservative capital requirements, margins, and reporting requirements. To the Treasury's proposal, I would also recommend adding stop-loss provisions that regulators could use to limit the promises made and losses suffered by systemically important financial institutions as a result of their trading in financial derivative contracts.
  • Set guidelines for individual compensation systems at systemically important financial institutions in order to better align the personal rewards of traders with the interests of shareholders and the public."

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